In January 2017, the Canadian Securities Administrators (CSA), an umbrella group for the provincial and territorial securities commissions across Canada, released its much- anticipated consultation paper on the option of moving Canada away from embedded fees for mutual funds in favour of a model that would see investors pay dealers directly for advice.
The consultation paper cites research findings consistent with the CSA's long-held view that embedded commissions “encourage suboptimal behaviour" across all segments of the financial industry—fund members, dealers, registered representatives and investors —which, in turn, “reduces market efficiency and impairs investor outcomes."1
Embedded commissions “encourage suboptimal behaviour"
These concerns are not new, as they come more than 20 years after former Ontario Securities Commission head, Glorianne Stromberg first argued in 1995 that embedded commissions create a conflict that “misaligns" the interests of the investment fund industry and investors, as advisors are motivated by the presence of embedded commissions. Similar bans have already been implemented in the UK, Australia, and the Netherlands. If adopted, the proposed ban would apply to funds and structured products in both the regulated and exempt markets.
The release of the paper marked the launch of an extended 150-day consultation period (ending June 9, 2017), to allow the investment industry and investors alike sufficient time to respond.
Industry Groups Advise Go-Slow Mode
The Investment Funds Institute of Canada (IFIC), an industry association for mutual funds, responded to the CSA paper by saying that eliminating embedded commissions “could significantly disrupt access to investment advice for many investors," as roughly 4.5 million Canadian households now pay for their investment fund fees via commissions.2
Roughly 4.5 million Canadian households now pay for their investment fund fees via commissions
IFIC had originally urged the CSA to delay the consultation paper until the impact of other reforms now underway are better understood—including new disclosure rules that are now being rolled out to ensure investors see the costs they are paying for advice.
Paul Bourque, IFIC president and CEO says “both regulators and governments should understand whether the cost of banning embedded commissions is proportionate to the regulatory objective of mitigating conflicts of interest," noting that “the industry is disappointed that the CSA has chosen not to consult on less disruptive alternatives and have limited the consultation to one option—a complete prohibition."
Advocis, a voluntary professional organization of financial planners in Canada, stated that in calling for a ban on embedded commissions, regulators “aren't seeing the full picture," as the commission model “allows 'Main Street' Canadians to access affordable advice that will put them on the road to a secure financial future." Advocis president and CEO Greg Pollock, CFP adds that “studies tell us that consumers prefer to pay for financial advice through fees that are part of their mutual funds."3
Regulators are putting the onus on the industry to determine the best compensation arrangement for their business and clients, which may include upfront commissions (like front-end sales loads), hourly fees, flat fees or a fee based on client portfolio size. Additional compensation arrangements are also possible, such as when a direct fee is paid in connection with the purchase of a security or other service.
Fee Ban Would Place New Pressures on Funds
The CSA expects that the proposed ban would cause fees on passive investment funds to drop by 0.4 percent and on actively managed funds by 0.75 percent
Funds with embedded commissions, no matter how or when they are paid, may face significant challenges under the proposed reforms. The CSA estimates that in aggregate, up to 44 percent of actively managed fund assets may be “redeemed or reallocated to competitor investment fund managers over time" if embedded commissions are discontinued and these managers are not able to adjust their fees or improve performance. The CSA also expects that the proposed ban would cause fees on passive investment funds to drop by 0.4 percent and on actively managed funds by 0.75 percent.
Advisory and industry groups have cautioned that a drop in fees does not necessarily help smaller investors who may either prefer to pay via bundled or embedded fees—or who may be unable to access suitable advice if the total number of advisors decreases under the new rules, or the direct-pay arrangements put the cost of financial advice out of reach of the smaller investor. They also note that as greater transparency about existing fee levels is only now being made available to individual investors via their account statements, it is too early to clearly gauge how investors feel about and will respond to increased awareness of existing fee arrangements.
For its part, the CSA has said a conclusion about the potential ban “will only be reached after careful consideration and assessment of the potential impacts on investors and market participants." In the interim, the CSA is calling on the investment industry to “create market-driven solutions and innovations" to respond to the changing landscape of fund management.
- Canadian Securities Administrators (January 10, 2017) - Canadian Securities Regulators Seek Input on Potential Impacts of Discontinuing Embedded Commissions
- The Investment Funds Institute of Canada (January 10, 2017) - Weigh investor benefits carefully before disrupting millions of Canadian account holders
- Wealth Professional (June 25, 2013) - Embedded Commissions: the affordable way?